Chapter 9

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9. Keynesian
Macroeconomics in the
AD-AS Model
Abel, Bernanke and Croushore
(chapter 11)

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Syllabus Outline
1. Introduction to Macroeconomics
2. The measurement and structure of the national economy
3. Goods market equilibrium: the IS curve
4. Money market equilibrium: the LM curve
5. The IS-LM model
6. Demand-side policies in the IS-LM model (Keynesian
Macroeconomics)
7. The Aggregate Supply curve
8. Classical Macroeconomics in the AD-AS model
9. Keynesian Macroeconomics in the AD-AS model
10. The relationship between Unemployment and Inflation

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A) Present the central ideas of Keynesian
macroeconomics
1. Wages and prices don’t adjust quickly to restore
general equilibrium
2. The economy may be in disequilibrium for long
periods of time
3. The government should act to stabilize the
economy
B) Discuss the potential causes of wage and
price rigidity
Our goals in this chapter

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Real-Wage Rigidity (Sec.11.1)
A) Wage rigidity is important in explaining
unemployment
B) Some reasons for real-wage rigidity
C) The Efficiency Wage Model
D) Wage determination in the efficiency wage
model
E) Employment and Unemployment in the
Efficiency Wage Model
F) Efficiency wages and the FE line

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Real-Wage Rigidity
A) Wage rigidity is important in explaining unemployment
1. In the classical model, unemployment is due to
mismatches between workers and firms
2. Keynesians are skeptical, believing that recessions lead to
substantial cyclical employment
3. To get a model in which unemployment persists,
Keynesian theory posits that the real wage is slow to adjust to
equilibrate the labor market

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Real-Wage Rigidity
B) Some reasons for real-wage rigidity
1. For unemployment to exist, the real wage must
exceed the market-clearing wage
2. If the real wage is too high, why don’t firms
reduce the wage?
a. One possibility is that the minimum wage and labor
unions prevent wages from being reduced
b. Another possibility is that a firm may want to pay high
wages to get a stable labor force and avoid turnover
costs—costs of hiring and training new workers
c. A third reason is that workers’ productivity may depend
on the wages they’re paid—the efficiency wage model

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Real-Wage Rigidity
C) The Efficiency Wage Model
1. Workers who feel well treated will work harder
and more efficiently (the “carrot”); this is Akerlof’s
gift exchange motive
2. Workers who are well paid won’t risk losing their
jobs by shirking (the “stick”)
3. Both the gift exchange motive and shirking model
imply that a worker’s effort depends on the real
wage (Figure 11.1)

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Figure 11.1 Determination of the Efficiency Wage

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Real-Wage Rigidity
C) The Efficiency Wage Model (cont.)
4. The effort curve, plotting effort against the
real wage, is S-shaped
a. At low levels of the real wage, workers make hardly any
effort
b. Effort rises as the real wage increases
c. As the real wage becomes very high, effort flattens out
as it reaches the maximum possible level

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Real-Wage Rigidity
D) Wage determination in the efficiency wage model
1. Given the effort curve, what determines the real wage firms
will pay?
2. To maximize profit, firms choose the real wage that gets
the most effort from workers for each dollar of real wages
paid
3. This occurs at point B in Figure 11.1, where a line from the
origin is just tangent to the effort curve
4. The wage rate at point B is called the efficiency wage
5. The real wage is rigid, as long as the effort curve doesn’t
change

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Real-Wage Rigidity
E) Employment and Unemployment in the
Efficiency Wage Model
1. The labor market now determines employment
and unemployment, depending on how far above
the market-clearing wage is the efficiency wage
(Figure 11.2)

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Figure 11.2 Excess supply of labor in the efficiency wage model

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Real-Wage Rigidity
E) Employment and Unemployment in the Efficiency
Wage Model (cont.)
2. The labor supply curve is upward sloping, while the labor
demand curve is the marginal product of labor when the
effort level is determined by the efficiency wage
3. The difference between labor supply and labor demand is
the amount of unemployment
4. The fact that there’s unemployment puts no downward
pressure on the real wage, since firms know that if they
reduce the real wage, effort will decline
5. Does the efficiency wage theory match up with the data?

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Real-Wage Rigidity
F) Efficiency wages and the FE line
1. The FE line is vertical, as in the classical model,
since full-employment output is related to
equilibrium employment obtained in the labor
market and does not depend on the price level
2. But in the Keynesian model, changes in labor
supply do not affect the FE line, since they don’t
affect equilibrium employment
3. A change in productivity does affect the FE line,
since it affects labor demand

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Price Stickiness (Sec. 11.2)
A) Price stickiness is the tendency of prices to
adjust slowly to changes in the economy
1. The data suggests that money is not neutral, so
Keynesians reject the classical model (without
misperceptions)
2. Keynesians developed the idea of price
stickiness to explain why money isn’t neutral
3. An alternative version of the Keynesian model
(discussed in Appendix 11.A) assumes that
nominal wages are sticky, rather than prices; that
model also suggests that money isn’t neutral

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Price Stickiness
B) Sources of price stickiness: Monopolistic
competition and menu costs
1. Monopolistic competition
2. Menu costs and price stickiness
3. Empirical evidence on price stickiness
4. Meeting the demand at the fixed nominal price
5. Effective labor demand

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Price Stickiness
B) Sources of price stickiness: Monopolistic competition
and menu costs
1. Monopolistic competition
a. If markets had perfect competition, the market would force
prices to adjust rapidly; sellers are price takers, because they
must accept the market price
b. In many markets, sellers have some degree of monopoly; they
are price setters under monopolistic competition
c. Keynesians suggest that many markets are characterized by
monopolistic competition
d. In monopolistically competitive markets, sellers do three things
(1) They set prices in nominal terms and maintain those prices
for some period
(2) They adjust output to meet the demand at their fixed
nominal price
(3) They readjust prices from time to time when costs or
demand change significantly

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Price Stickiness
competition and menu costs (cont.)
2. Menu costs and price stickiness
(1) The term menu costs comes from the costs faced by a
restaurant when it changes prices—it must print new
menus
(2) Even small costs like these may prevent sellers from
changing prices often
(3) Since competition isn’t perfect, having the wrong price
temporarily won’t affect the seller’s profits much
(4) The firm will change prices when demand or costs of
production change enough to warrant the price change

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Price Stickiness
and menu costs (cont.)
3. Empirical evidence on price stickiness
(1) Industrial prices seem to be changed more often in
competitive industries, less often in more monopolistic
industries (Carlton study)
(2) Blinder and his students found a high degree of price
stickiness in their survey of firms
(a) The main reason for price stickiness was managers’
fear that if they raised their prices, they’d lose
customers to rivals
(3) But catalog prices also don’t seem to change much from one
issue to the next and often change by only small amounts,
suggesting that while prices are sticky, menu costs may not
be the reason (Kashyap)

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Table 11.1 Average Times Between Price Changes for Various Industries

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Table 11.2 Frequency of Price Adjustment Among Interviewed Firms

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Price Stickiness
and menu costs (cont.)
4. Meeting the demand at the fixed nominal price
(1) Since firms have some monopoly power, they price goods at a
markup over their marginal cost of production:
P = (1 + η)MC (11.1)
(2) If demand turns out to be larger at that price than the firm
planned, the firm will still meet the demand at that price, since
it earns additional profits due to the markup
(3) Since the firm is paying an efficiency wage, it can hire more
workers at that wage to produce more goods when necessary
(4) This means that the economy can produce an amount of
output that is not on the FE line during the period in which
prices haven’t adjusted

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Price Stickiness
competition and menu costs (cont.)
5. Effective labor demand
(1) The firm’s labor demand is thus determined by the
demand for its output
(2) The effective labor demand curve, NDe(Y), shows how
much labor is needed to produce the output demanded
in the economy (Figure 11.3)
(3) It slopes upward from left to right because a firm needs
more labor to produce additional output

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Figure 11.3 The effective labor demand curve

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Monetary and Fiscal Policy in the
Keynesian Model (Sec. 11.3)
A)Monetary policy
1. Monetary policy in the Keynesian IS-LM model
a. The Keynesian FE line differs from the classical model in two
respects
(1) The Keynesian level of full employment occurs where
the efficiency wage line intersects the labor demand
curve, not where labor supply equals labor demand,
as in the classical model
(2) Changes in labor supply don’t affect the FE line in the
Keynesian model; they do in the classical model
b. Since prices are sticky in the short run in the Keynesian model,
the price level doesn’t adjust to restore general equilibrium
(1) Keynesians assume that when not in general
equilibrium, the economy lies at the intersection of
the IS and LM curves, and may be off the FE line
(2) This represents the assumption that firms meet the
demand for their products by adjusting employment
c. Figure 11.4 (next)

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(1) LM curve shifts down from LM1 to LM2
(2) Output rises and the real interest rate falls
(3) Firms raise employment and production
due to increased demand
(4) The increase in money supply is an
expansionary monetary policy (easy money);
a decrease in money supply is contractionary
monetary policy (tight money)
(5) Easy money increases real money supply,
causing the real interest rate to fall to clear
the money market
(a) The lower real interest rate
increases consumption and
investment
(b) With higher demand for
output, firms increase
production and employment
(6) Eventually firms raise prices, the LM
curve shifts back to its original level, and
general equilibrium is restored
(7) Thus money is neutral in the long run, but
not in the short run

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B)Monetary Policy in the Keynesian AD-AS framework
1. We can do the same analysis in the AD-AS framework, as
was done in text Figure 9.14
2. The main difference between the Keynesian and classical
approaches is the speed of price adjustment
a. The classical model has fast price adjustment, so the SRAS
curve is irrelevant
b. In the Keynesian model, the short-run aggregate supply
(SRAS) curve is horizontal, because monopolistically
competitive firms face menu costs
3. The effect of a 10% increase in money supply is to shift the
AD curve up by 10%
a. Thus output rises in the short run to where the SRAS curve
intersects the AD curve
b. In the long run the price level rises, causing the SRAS curve to
shift up such that it intersects the AD and LRAS curves
4. So in the Keynesian model, money is not neutral in the short
run, but it is neutral in the long run
Keynesian Model

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C) Fiscal Policy
1. The effect of increased government purchases
(Figure 11.5)
Keynesian Model

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C) Fiscal Policy (cont.)
a. A temporary increase in government purchases shifts the IS
curve up
b. In the short run, output and the real interest rate increase
c. The multiplier, ∆Y/∆G, tells how much increase in output comes
from the increase in government spending
(1) Keynesians think the multiplier is bigger than 1, so
that not only does total output rise due to the increase
in government purchases, but output going to the
private sector increases as well
(2) Classical analysis also gets an increase in output, but
only because higher current or future taxes caused
an increase in labor supply, a shift of the FE line
(3) In the Keynesian model, the FE line doesn’t shift,
only the IS curve does
d. When prices adjust, the LM curve shifts up and equilibrium is
restored at the full-employment level of output with a higher
real interest rate than before
Keynesian Model

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e. Similar analysis comes from looking at the AD-AS
framework (Figure 11.6)
Keynesian Model

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2. The effect of lower taxes
a. Keynesians believe that a reduction of (lump-sum) taxes
is expansionary, just like an increase in government
purchases
b. Keynesians reject Ricardian equivalence, believing that
the reduction in taxes increases consumption spending,
reducing desired national saving and shifting the IS
curve up
c. The only difference between lower taxes and increased
government purchases is that when taxes are lower,
consumption increases as a percentage of full-
employment output, whereas when government
purchases increase, government purchases become a
larger percentage of full-employment output
Keynesian Model

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The Keynesian Theory of Business Cycles
and Macroeconomic Stabilization (Sec. 11.4)
A) Keynesian business cycle theory
1. Keynesians think aggregate demand shocks are
the primary source of business cycle fluctuations
2. Aggregate demand shocks are shocks to the IS or
LM curves, such as fiscal policy, changes in
desired investment arising from changes in the
expected future marginal product of capital, changes
in consumer confidence that affect desired saving,
and changes in money demand or supply
3. A recession is caused by a shift of the aggregate
demand curve to the left, either from the IS curve
shifting down, or the LM curve shifting up

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and Macroeconomic Stabilization
A) Keynesian business cycle theory (cont.)
4. The Keynesian theory fits certain business cycle
facts
a. There are recurrent fluctuations in output
b. Employment fluctuates in the same direction as output
c. Money is procyclical and leading
d. Investment and durable goods spending is procyclical
and volatile
(1) This is explained by the Keynesian model if shocks to
investment and durable goods spending are a main
source of business cycles
(2) Keynes believed in “animal spirits,” waves of
pessimism and optimism, as a key source of
business cycles
e. Inflation is procyclical and lagging
(1) The Keynesian model fits the data on inflation,
because the price level declines after a recession
has begun, as the economy moves toward general
equilibrium

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A) Keynesian business cycle theory (cont.)
5. Procyclical labor productivity and labor hoarding
a. As discussed in Sec. 11.1, firms may hoard labor in a
recession rather than fire workers, because of the costs
of hiring and training new workers
b. Such hoarded labor is used less intensively, being used
on make-work or maintenance tasks that don’t contribute
to measured output
c. Thus in a recession, measured productivity is low, even
though the production function is stable
d. So labor hoarding explains why labor productivity is
procyclical in the data without assuming that recessions
and expansions are caused by productivity shocks

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B) Macroeconomic stabilization
1. Keynesians favor government actions to stabilize the economy
2. Recessions are undesirable because the unemployed are hurt
3. Suppose there’s a shock that shifts the IS curve down, causing a
recession (text Figure 11.8)
a. If the government does nothing, eventually the price level will
decline, restoring general equilibrium. But output and employment
may remain below their full-employment levels for some time
b. The government could increase the money supply, shifting the LM
curve down to move the economy to general equilibrium
c. The government could increase government purchases to shift the
IS curve back up to restore general equilibrium

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B) Macroeconomic stabilization (fig. 11.8)

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B) Macroeconomic stabilization (cont.)
4. Using monetary or fiscal policy to restore general
equilibrium has the advantage of acting quickly,
rather than waiting some time for the price level to
decline
5. But the price level is higher in the long run when using
policy than it would be if the government took no
action
6. The choice of monetary or fiscal policy affects the
composition of spending
a. An increase in government purchases crowds out
consumption and investment spending, because of a higher
real interest rate
b. Tax burdens are also higher when government purchases
increase, further reducing consumption

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7. Difficulties of macroeconomic stabilization
a. Macroeconomic stabilization is the use of monetary and
fiscal policies to moderate the business cycle; also called
aggregate demand management
b. In practice, macroeconomic stabilization hasn’t been terribly
successful
c. One problem is in gauging how far the economy is from full
employment, since we can’t measure or analyze the state of
the economy perfectly
d. Another problem is that we don’t know the quantitative
impact on output of a change in policy
e. Also, because policies take time to implement and take
effect, using them requires good forecasts of where the
economy will be six months or a year in the future; but our
forecasting ability is quite imprecise
f. These problems suggest that policy shouldn’t be used to “fine
tune” the economy, but should be used to combat major
recessions

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8. Box 11.2: Japanese Macroeconomic Policy in the 1990s
a. From 1960 to 1990, Japan’s economy grew over 6% per year and became
the envy of the world
b. But the Japanese economy slumped in the 1990s, with growth near zero
(1) Stock and land prices fell from excessive levels, hurting banks
(2) Bank’s financial distress caused lending to fall, reducing
investment
(3) Insurance companies and government financial institutions also
suffered substantial loan losses
c. The Keynesian solution was to use expansionary monetary and fiscal
policies, which Japan tried
d. But the economy didn’t respond because of a liquidity trap
(1) Nominal interest rates became zero
(2) Since nominal interest rates can’t go below zero, monetary policy
was ineffective
e. Critics argue that the Japanese government didn’t do enough to stimulate
the economy
(1) Fiscal stimulus could have been greater, combined with more
expansionary monetary policy
(2) Even with a flat LM curve, shifting the IS curve up enough will get
the economy back to full employment

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Box 11.2 Japanese Macroeconomic Policy in the 1990s

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C) Supply shocks in the Keynesian model
1. Until the mid-1970s, Keynesians focused on
demand shocks as the main source of business
cycles
2. But the oil price shock that hit the economy
beginning in 1973 forced Keynesians to
reformulate their theory
3. Now Keynesians concede that supply shocks can
cause recessions, but they don’t think supply
shocks are the main source of recessions
4. An adverse oil price shock shifts the FE line left
(text Figure 11.9)

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a. The average price level rises, shifting the
LM curve up (from LM1 to LM2),
because the large increase in the price of oil
outweighs the menu costs that would
otherwise hold prices fixed
b. The LM curve could shift farther than the
FE line, as in the figure, though that isn’t
necessary
c. So in the short run, inflation rises and
output falls
d. There’s not much that stabilization policy
can do about the decline in output that
occurs, because of the lower level of full-
employment output
e. Inflation is already increased due to the
shock; expansionary policy to increase output
would increase inflation further

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Figure 11.9 An oil price shock in the Keynesian model

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Appendix 11.A: Labor Contracts and
Nominal-Wage Rigidity
A) Some Keynesians think the nonneutrality of
money is because of nominal-wage rigidity,
not nominal-price rigidity
1. Nominal wages could be rigid because of long-
term contracts between firms and unions
2. With nominal-wage rigidity, the short-run
aggregate supply curve slopes upward instead of
being horizontal
3. Even so, the main results of the Keynesian model
still hold

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B) The short-run aggregate supply curve with
labor contracts
1. U.S. labor contracts usually specify employment
conditions and the nominal wage rate for three
years
2. Employers decide on workers’ hours and must pay
them the contracted nominal wage
3. The result is an upward-sloping short-run
aggregate supply curve
a. As the price level rises, the real wage
declines, since the nominal wage is fixed
b. As the real wage declines, firms hire more
workers and thus increase output

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C) Nonneutrality of money
1. Money isn’t neutral in this model, because as the money
supply increases, the AD curve shifts along the fixed (upward-
sloping) SRAS curve (text Figure 11.A.1)

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C) Nonneutrality of money (cont.)
2. As a result, output and the price level increase
3. Over time, workers will negotiate higher nominal wages and
the SRAS curve will shift left to restore general equilibrium
4. Thus money is nonneutral in the short run but neutral in the
long run
5. There are several objections to this theory
a. Less than one-sixth of the U.S. labor force is unionized and
covered by long-term wage contracts; however, some
nonunion workers get wages similar to those in union
contracts, and other workers may have implicit contracts that
act like long-term contracts
b. Some labor contracts are indexed to inflation, so the real wage
is fixed, not the nominal wage; however, most contracts aren’t
completely indexed
c. The theory predicts that real wages will be countercyclical, but
in fact they are procyclical; however, if there are both
aggregate supply shocks and aggregate demand shocks, real
wages may turn out on average to be procyclical, but could still
be countercyclical for demand shocks

Chapter 9

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